Avoid a Surprise Tax Bill by Preparing for R&D Expensing Changes Under IRC 174

Avoid a Surprise Tax Bill by Preparing for R&D Expensing Changes Under IRC §174

by David Greenamyre, Tom Pyevich
July 13, 2022

Updated August 16, 2023

For nearly 70 years, companies have been allowed to expense R&D costs as paid or incurred allowing for an immediate tax deduction under Internal Revenue Code (IRC) §174. The immediate tax deduction allowed under IRC §174 (along with the R&D tax credit) has stimulated private-sector R&D spending for decades. Several industries, particularly those in the technology sector, reinvest earnings and their outside funding directly into R&D spend — causing many to be “loss” companies for both GAAP and tax purposes.

Beginning in 2022, immediate R&D expensing is no longer an option. In December of 2017, the Tax Cuts and Jobs Act (TCJA) amended IRC §174 to require R&D expenditures to be capitalized and amortized over a period of 5-15 years for amounts paid in tax years beginning after December 31, 2021. Additionally, internal software development costs are specifically included as R&D expenditures under the amended IRC §174 and are therefore required to be capitalized and amortized.

What Does This Change Mean for Companies?

Now that immediate R&D expensing is no longer an option, many companies may find that they have a substantial amount of taxable income and do not have the tax losses they were expecting. Year one (2022) creates a significant tax impact because only half-year amortization is allowed.

For example, assume SaaS Company, Inc. spends $70M on R&D in 2022 and has an overall GAAP loss of $30M for the year. The company will have to capitalize the entire $70M of R&D spend for tax purposes. Assuming five-year amortization and the required midpoint convention, the company would only be entitled to a $7M amortization tax deduction in 2022. Absent any other tax adjustments, the company would have $33M in taxable income for 2022:

(“old” IRC §174 in effect)
(“new” IRC §174 in effect)
GAAP EBIT -$30M -$30M
R&D Spend - +$70M
5-year tax amortization - R&D - -$7M
Taxable Income* -$30M +$33M

*Assumes no other tax adjustments

Even with an unexpected taxable income position, companies may assume they have tax attribute carryforwards to offset the income (e.g., net operating losses (NOL) and tax credits). These attributes are often limited and not available to offset taxable income.

For example, IRC §382 limits the amount of tax attributes due to ownership changes that may have occurred. Furthermore, post-2017 Federal NOLs are limited to 80% of taxable income. Most states conform to the amended §174 and have similar limits on tax attribute utilization. Additionally, many states have specific attribute limitations in place as revenue raisers for their fiscal budgets. (Connecticut only allows taxable income to be offset by 50% of carryforward NOLs and Illinois has a $100K cap on any NOL utilization.)

What this all means is that company stakeholders, the C-suite, treasury function and the tax function should be aware of current law and plan for the very likely scenario of unexpected cash taxes. With valuations plummeting, market volatility, and the uncertainty of a recession, most companies are watching cash spend closely and forecasting their runway. To avoid a surprise tax bill on top of all of this, understand the changes.

Section 174: What Is Holding True

Few business leaders expected the new R&D expensing rules to become a true concern, and neither did the politicians who enacted them. This provision of the TCJA mainly served as a revenue raiser that allowed the bill to pass through budget conciliation rather than having to garner a supermajority in the Senate. As such, it was widely regarded as a temporary bit of legislation that would be eliminated before it hit anyone’s bottom line. And yet, here we are in 2023, with extended 2022 tax deadlines approaching rapidly and R&D amortization the law of the land.

The policy is an international anomaly that puts U.S. companies at a competitive disadvantage relative to foreign peers. Worse yet, the lack of immediate expensing for R&D costs is creating massive headaches for business leaders due to a lack of guidance to address technical questions around compliance. With no clear methodology to follow, companies are largely in the dark about how to appropriately allocate indirect costs, risk-related expenses and other costs under the newly enacted law.

Members of Congress are well aware of the havoc caused by this legislation, and there’s bipartisan support to repeal this portion of the TCJA, or at least to impose a 5-year moratorium. Until new legislation is enacted, however, companies have no choice but to make a good faith effort to comply.

Expense Classification: What the Guidance Tells Us

Distinguishing between Section 174-eligible costs and Section 162 ordinary business expenses is a major stumbling block for businesses with R&D activity — especially software companies.

These key distinctions can help you classify expenses correctly:

  • Administrative, human resources, accounting, sales and customer service typically fall under the heading of immediately deductible, ordinary business expenses.
  • Likewise, “fixing what’s broken” qualifies as a Section 162 expense if it’s standard maintenance for normal operations or customer support.
  • However, costs incurred to conceive and develop a new product are considered R&D and must be amortized under Section 174.
  • Process improvements, upgrades, enhancements and automating manual processes are all activities that properly qualify under Section 174.
  • For software companies, Section 174 R&D expenses include the costs associated with adding new feature sets, validating new or improved code, brainstorming functionality improvements and working toward a subsequent version of existing software.
  • Labor costs for full-time staff and outside contractors you pay to develop, improve, test or experiment with software must also be amortized under Section 174 — over five years for U.S. workers and 15 years for those based elsewhere.

Business Strategy for Current Section 174 Expensing Rules

Given the reality of TCJA requirements related to Section 174 expenses, adopting a strategic approach to handling these changes is imperative for all businesses that conduct R&D.

The shift in tax policy can create a dramatic financial impact; some companies are facing three to four times their previous year’s tax liability. And for many companies, the revised Section 174 regulations coupled with limitations on NOL and other tax carryforwards are moving businesses to a taxable position for the first time.

The half-year convention effectively allows businesses to deduct just 10% of their previously allowable research and experimentation expenses in 2022 (20% in 2023 and subsequent years). Entities that include foreign subsidiaries will suffer an even stronger blow for the 2022 tax year; under the Section 174 rules, they can only deduct 1/30 of previously deductible R&D costs conducted in non-U.S. locations or provided by non-U.S. workers during the first year the law is effective (1/15 in future years).

Ways to minimize the tax impact of the change

What can you do to minimize the impact of such a drastic change? Getting serious about tax planning and maximizing tax efficiency is critical for your bottom line:

  • Remember the impact on quarterly estimated tax payments. If you’ve always factored in a big deduction for R&D expenses to reduce or eliminate your annual tax bill, it’s time to plan for a larger tax impact. Adjust your quarterly estimates to incorporate the newly taxable income. Underpayment penalties will only make a bad tax situation worse.
  • Take advantage of a one-year streamlined accounting change process. The IRS has issued an amended procedure for reporting an accounting method change in tax year 2022 due to Section 174 expense capitalization and amortization. The whitepaper statement in lieu of the full Form 3115 is brief and simple, but if you miss this window you’ll have to complete and submit the full Form 3115 later — a far more onerous process that carries significant risk. Failing to take the opportunity for tax year 2022 also means you’ll be noncompliant, which triggers additional consequences.
  • Perform an R&D study to identify expenses that may offset newly taxable income. The R&D tax credit is even more valuable now in offsetting additional tax liability under the Section 174 regulations. The amended rules require your business to conduct this analysis to determine which expenses qualify under Section 174 and which may be properly deducted under Section 162. It makes good financial sense to go one step further and have tax professionals perform an R&D study. This will not only provide confidence that you’re allocating correctly, it could also help you identify overlooked deductible expenses to reduce your tax burden.
  • Establish a tax-efficient process for future years. While the Section 174 issues may be a short-lived problem, you must be prepared to perform an annual impact analysis as long as the law exists in its current form. Work with tax professionals who can help you develop a process for Section 174 compliance, including training your internal staff to correctly identify and classify various costs that fall under the different sections of the IRS code.

The loss of full, immediate deductibility of R&D expenses is an unpleasant blow that can significantly alter the business financial equation, but it’s not the end of the world. With proper guidance and a strategic approach to tax management, your company can adapt to this new framework and thrive. Identifying, documenting and claiming the full value of all your supported R&D costs can restore balance and minimize the increase in total tax owed under the new standard.

Maximize Your Tax Credits Under the New Section 174

Not every business has R&D expenditures, but a surprising number of companies do incur this type of expense, and these costs often go unrecognized. Contact our tax credit experts to learn how we can help you stay compliant with Section 174 and capture the maximum value of available R&D tax credits.

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